09 Oct Getting off Track by John Taylor
The latest book review in my ongoing series pertaining to the financial catastrophe of 2008 brings me to the delightful Dr. John Taylor, a Senior Fellow at the Hoover Institution and prominent economist throughout the last 35 years. His tiny work, Getting off Track, is a very quick read, but worthy of attention nonetheless.
Dr. Taylor suggests that, at least as it pertains to government policy, (1) Overly accomodative interest rates from 2002-2005 caused the financial crisis; (2) A misdiagnosis of the problem as liquidity risk, as opposed to solvency risk, prolonged the crisis; and, (3) Failing to develop any kind of predictable framework for dealing with it dramatically worsened the prolonged crisis (i.e. ad hoc and arbitrary interventionism that left markets confused and investors panicked).
Not surprisingly, Dr. Taylor focuses his claim that the crisis was caused by setting interest rates too low, for too long, by blaming the Fed on their abandoment of the so-called “Taylor rule” (yes, named after the author himself). The Taylor Rule (as it is frequently labeled by the financial press) demands a definitive policy of raising rates when inflation increases and lowering rates when GDP declines. It does provide a formulaic methodology for how this ought to be done. Taylor suggests that Greenspan abandoned the Taylor Rule in his response to events earlier in the decade, and this monetary lapse of judgment led us astray.
I think much of this brief primer is very valuable, and I find the thesis that the 2007 identification by policy-makers that we were suffering a “liquidity crisis”, as opposed to a real-life solvency crisis in the financial markets, is very compelling. Policy response can not be expected to be effectual if the problem the response is intended to address is the wrong problem. I intend to flush this point out in later disussion, but I find this area of the book to be the most important. The Bush stimulus plan of early 2008 was an utter failure, as any economist who saw what was happening in the LIBOR markets could have told us (and, as anyone who has remotely studied Friedman’s indisputable Permanent Income Theory did tell us). What I mean is this: LIBOR OIS spreads told us that the real issues in the financial markets were global skepticism about the health of the financial companies. We did not have a problem of inadequate liquidity, thereby making short term fixes like the Term Auction Facility inadequate. Consumers did not spend their rebate checks in any meaningful way, as Friedman told us they would not. Fiscal and monetary policies diagnosed insulin for a cancer patient and chemotherapy for a diabetes patient, and leaders were shocked in mid-2008 when the treatments were not working.
The one criticism I would offer of Taylor’s work is the extraordinary self-congratulatory nature it takes on from start to finish. I have not met a Ph.D from Stanford who did not have a high opinion of himself, particularly one of Dr. Taylor’s pedigree, so perhaps this is not surprising. But I think the “I told you so” tone of the book is unnecessary. Regardless, it is a fine work from a top-notch economist. I can not condone his romanticizing of the so-called “Great Moderation” (from 1980-2000) wherein he believes monetary policy operated flawlessly. Indeed, I believe far more credit for the economic expansion of that period lies with the tax policy of Ronald Reagan (marginal rate reduction), and the trade policy of Bill Clinton (global expansion). This is not to say that the Fed rate policy of the period prior to 2002-2005 was always wrong, for it was not, and I do believe (in theory) that some type of systematic “Taylor Rule” makes a lot of sense in central bank policy. He is right to blast Greenspan for the easy-money sins of 2002-2005; I am just not convinced that these sins came out of nowhere. But Taylor is a brilliant economist, a respected thinker, and has done good work here in breaking down for readers a simple analysis of the multiple failures that caused and prolonged this crisis.